July-August 2011

Socially responsible investment funds sell the idea that we can actively help create a sustainable future. Nick Fitzpatrick asks if investors can really make a difference - and if SRI makes a difference to investor's portfolios.

It is ten years since FTSE, the index provider, launched its FTSE4Good family of indices that indexes companies with the best social and green credentials. They were heady days for ethical and environmental investing when the indices came out in July 2001 – particularly in the UK where the then-Labour government had called on pension schemes to state whether they use any kind of socially responsible investment (SRI) criteria or not.

That government measure reinvigorated the ethical investment funds industry, which adopted the SRI acronym, and a flurry of products quickly came to market.

Since then, the financial argument in favour of SRI has expanded. It now encompasses ideas that companies can increase their profitability if they engage with environmental, social and governance (ESG) issues, and that an SRI strategy can bring diversification when run alongside ordinary portfolios.

But the latter argument – which rests partly on the belief that companies with better risk management around ESG factors will negatively correlate with those that do not – was tested like all other strategies by the financial crisis, and it did not fare too well.

SRI did not provide protection against the market downturn, acknowledge Christoph Butz and Laurent Nguyen, of Switerland’s Pictet Asset Management.

Also, Edhec, the French business school, found that although eight out of ten SRI indices performed better than non-SRI indices from January 2007 to December 2009, this was not statistically significant.

In a report entitled Surviving the next crisis, Butz and Nguyen suggest ways to make SRI more credible, centring on what they call “financial sustainability”, which includes a dislike of excessive leverage.

Meanwhile, FTSE analytics has produced data to show companies with high ESG risks are more associated with market beta. This should support those who argue that SRI can provide alpha for those who know where to find it.

Normal thinkingAs the climate for SRI investing shifts, the climate change element of SRI is itself still a hot topic. Whether it is caused by humans or not, climate change is broadly accepted and the issue gets two rolls of the investors’ dice: one for its return-generating opportunities in the technology and energy sectors; and another for its risk management function in spotting the financial impact of climate change on other kinds of investments.

An investment management company such as UK-listed Schroders reflects how climate change has become part of normal thinking. Alan Brown, the chief investment officer, told Funds Europe in May last year that he thinks solutions to climate change could be the biggest driver of growth in the coming generation, along with emerging markets.

In terms of the financial impact of climate change on other investments, Schroders follows data that seeks to plot a correlation between agricultural index returns and the La Niña ocean-atmosphere phenomenon.

Embedded thinking about negative climate change impact on investments is seen elsewhere in institutional asset management as well. Climate change is not only an issue affecting agricultural-based investments, but according to Tim Clare, head of environmental due diligence at consultancy WSP Environment & Energy, real estate investment managers take climate change-related flood risk as seriously today as they have done other environmental factors, such as contaminated land, in the past.

“Climate change is killing deals now because of flooding,” he says. “Institutional investors in real estate will want to know if a property sits in a flood plain, and if the risk of flooding is above a certain level, it can halt a deal.”

Clare adds that thinking how the climate issue may affect future property values is also causing institutional investors to consider energy usage.

“In office space, the number one way for top-flight companies, particularly service companies, that are trying to demonstrate they are green is to have a green building, so landlords know that these kinds of tenants will only want buildings with the best energy ratings possible.”

Clare also consults about the environmental and climatic issues surrounding mergers and acquisitions (M&A) activity outside real estate and from there he says he can see the effects on commodity-based companies – for example, the threat of deforestation is important to large tea buyers.

And if the climate is not a direct threat, then there is the indirect threat wrought by regulation, which is getting stronger. Mercer Investment Consulting estimates that climate policy could contribute as much as 10% to overall portfolio risk in the next 20 years.

For Peter Michaelis, head of SRI at Aviva Investors, factoring in regulatory costs is a sign of how far “climate proofing” has come. He was at Henderson Global Investors, then moved to Morley (now Aviva) in 2000. Both Henderson and Morley were significant launchers of SRI funds then.

Michaelis says: “[Around 2000] climate change was viewed as something very “Greenpeace” and not for people interested in finance. Companies did not produce environmental reports of any sort. It was a bold step by Henderson and Morley to invest in it.

“If you fast-forward to today, any mainstream utilities analyst in Europe will model CO2 permits into their pricing of stocks.”

Ringing corporate changeBut apart from these differences, has he seen a change in company behaviour over tackling climate challenge? After all, investing in SRI funds for financial reasons, such as diversification, is one thing, but implicit in these funds – especially for the retail investor – is the idea that they can ring changes out of companies and create susstainable future.

“There are no truly sustainable companies,” says Michaelis. “But we engage with laggards. We have voted against companies that do not provide sufficient disclosure about environmental and social issues and we find that about 50% of the time they adopt disclosure.”

He adds: “Each year we raise the bar.”

FTSE says its indices have forced changes in corporate behaviour, too, including over climate change. Academics from the University of Edinburgh recently showed that when FTSE tightened its criteria for inclusion in FTSE4Good indices, the majority of companies already in the indices responded. A control group outside the indices and which was not engaged with, also changed their practice – but far fewer of them did so compared with index members, suggesting a link between index inclusion and action over climate change.

“There is competition between them because everybody wants to be top quartile,” says David Harris, director of responsible investment at FTSE Group, which has strengthened the ESG inclusion requirements for the FTSE4Good indices five times in the last ten years.

Harris says the indices have increasingly appealed to institutions since their launch, partly as a benchmark, partly as a diversifier.

In 2008, FTSE launched a further set of SRI indices called the FTSE Environmental Markets Index Series. These offer a greater climate change exposure than FTSE4Good using two sets of indices, one focused on technology, and a broader “opportunities” range.

Harris says: “A number of institutionswanted to make an allocation to clean tech but found it a very confusing area owing to a lot of definitions about what counts as clean tech.”

Criteria are based on what proportion of revenues a company derives from products and services. For the technology index it must be a minimum of 50%, but there are companies with a market value of $250bn that get at least half their revenues from those sectors and this is only as large as Exxon Mobil, says Harris, and clients needed something broader that still offered meaningful exposure.

The Opportunities index, therefore, has a 50% threshold.

Asked if extending indices reduces their diversification benefits – even BP was in FTSE4Good until September last year – Harris says the $2 trillion market cap of the Opportunities series is just a small proportion of the $35 trillion global equity market. He says that nearly all 18 indices within FTSE Environmental Markets have outperformed global markets over the past five years.

One of the most comprehensive studies of indices was by Mercer, which considered 20 separate academic studies. Of these, ten had found a positive correlation, seven a neutral effect, and three a negative correlation. According to FTSE in its 10-year review of the FTSE4Good indices, while the results of the studies varied the conclusion was that there was no evidence of a performance penalty.

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